Workforce Holdings, lots of sales but no cash.

To some people who stumble across this blog the companies I write about are some of the strangest and most obscure things in the market.  For most readers who are familiar with these markets the names are common and there's nothing odd about the companies at all.  I often write about stocks foreign to Americans, but they're domestic to many readers, maybe unsurprisingly half of the readership for this blog comes from outside the US.  One place not many readers come from is Africa, an area I've wanted some exposure to for a while.  I've written about Africa in the past, a book review here, and about a Portuguese construction company with a lot of African exposure.

I ran a screen for South Africa looking for net-nets on a whim, one came back, Workforce Holdings (WKF.South Africa).  It shouldn't surprise anyone that the company is small with a market cap of roughly $14m USD or 122.4m ZAR.  After taking a cursory look I was smitten with Workforce, they had so many things going for them including:

• NCAV of 128.4m against a market cap of 122.4m
• Book value of 206m (91.4 ZAX (essentially cents, 100ths of the South African Rand ZAR))
• Trading with a P/E of 4.6x
• Revenue, operating profit, earnings and equity have all been consistently growing.

Note: The company can be traded through Fidelity after enabling their International Trading platform.

The company is a staffing company, they fill temporary employment needs for clients.  For example a company might have a period of time that's much busier and they need extra factory help, along with the extra factory help they might also need some accountants on a temporary basis, and HR individuals to temporarily hire all of the above.  Workforce can provide temporary employees to most industries and most positions within those industries across South Africa and in neighboring countries.  The majority of their staffing is outsourced industrial support.

One question to ask when looking at a cheap company is "why are they trading so low?"  I find this is the question most investors fail to ask, and it's usually the answer to this question that leads to the fulcrum of the investment.  Most investments rest on a few hinges, fulcrums, turning points.  For growth investors the fulcrum might be the release of a new product, or a new service.  If the product is successful the stock takes off.  Those of us digging in the mud of the market are looking at things a little different.  The fulcrum for distressed investors might be if a stock doesn't breach a covenant then it will result in gains.  With most of the cheap stocks I look at the fulcrum is finding out the bad thing the market expects and determining if that bad thing will happen, or if the market has overshot.  It's rare to find a net-net that's debt free, loaded down with cash, has shareholder friendly management, high margins and gushing cash.  If it does exist, and a few might they probably trades less than 100 shares a year, in that case illiquidity is the fulcrum.

The issue for Workforce Holdings is the South African labor laws have changed in a way that could harm Workforce's business model.  The latest annual report asserts this won't be the case, but the company's actions speak louder than the CEO's letter.  The company has expanded into other markets including financial and lifestyle products.  This division has a fancy name for payday and student loans.  The telling line in the annual report is when the company states they believe the financial and lifestyle products division will be the growth driver in the future.

After building up a preliminary thesis I set out to find reasons why I should never invest in this company.  I try to work in reverse when I research, instead of reading ten years worth of annual reports and writing a competitive analysis on an industry before performing a valuation I want to make sure something is cheap first.  Once I've determined it's cheap I set out to find a reason why I shouldn't invest.  If I can't overcome all of the negatives on a stock I move on, sometimes there aren't many negatives, or at the price the company's trading the negatives might not matter much.  If I were to buy UPS at 35x earnings I might be worried about how gas pricesaffect earnings, at 5x earnings and below book value gas prices aren't an issue anymore.

It actually took me a while before I found the fatal flaw with Workforce Holdings, I made it through their latest annual report, and all the notes before I had my lightbulb moment.  I put together a spreadsheet showing the last six years worth of results with the flaw highlighted:

I lied, there isn't one flaw, there are a few.  The first is that while the company has great earnings they have a lot of trouble converting their earnings into cash flow.  To compensate for this the company continues to accumulate more and more debt.

The second problem are the company's receivables.  For long term construction projects it might not be unusual to have a receivable entry that continues to grow for years before a project is completed.  Staffing is different, client companies are billed weekly or monthly for the services provided.  There isn't a long runout with staffing, a person works, they bill hours and Workforce is paid.  The problem is Workforce doesn't seem to be getting paid that often.

The company reported 130m in earnings over the past six and a half years yet had operating cash flows of -117m over that same period of time.

If the company is having a lot of trouble converting their earnings into cash I started to wonder about the quality of the receivables.  If the company can't convert the receivables into cash then are the receivables worth their stated value?  Applying a significant haircut to them destroys any margin of safety on this investment, especially at this price.

Another way to look at the balance sheet is from a lender perspective.  I considered that if I had millions of rands would I lend them to Workforce Holdings if they asked?  The company has already borrowed against their receivables, which means the only thing left to loan against is property and plant, or their earnings stream.  Book value appears high, the company highlights that book value is double the share price.  Book value starts to fall apart when reading the notes, property and plant is made up of software licenses, computers and office equipment.  These items all have value in generating earnings, but their book value is an accounting fiction.  I wouldn't loan against the earnings stream because as I mentioned above the earnings are mostly an accounting fiction as well, there is no cash to back those earnings.

I really wanted to like this investment, the initial thesis was tempting, plus the potential to be able to participate in the growing African labor market was compelling.  Unfortunately the company's inability to turn sales into cash flow turned me away from Workforce Holdings.  Unless they cleaned up their balance sheet and started to generate cash, I couldn't imagine being a buyer.

Talk to Nate

Disclosure: No Position